Regardless of where you live, how much you earn or what type of house you are shopping for, as soon as you find out how much the seller is asking, your first reaction might be something like, "Wow! That's expensive!" Your initial assessment is correct. With prices rising quickly, particularly in areas like New York and Boston, even starter homes can carry hefty six-figure price tags. Your next reaction is likely to be, "Can I afford that?"
Generally speaking, most prospective homeowners can afford to mortgage a property that costs between 2 and 2.5 times their gross income. Under this formula, a person earning $100,000 per year can afford to mortgage between $200,000 and $250,000. But this calculation is only a general guideline.
Tutorial: Mortgage Basics
Ultimately, when deciding on a property, you need to consider a few more factors. First, it's a good idea to have an understanding of what your lender thinks you can afford – to gain a precise idea of what size of mortgage their clients can handle, lenders use formulas that are much more complex and thorough. Secondly, you need to determine some personal criteria by evaluating not only your finances but also your preferences.
Lender's Criteria: Debt-to-Income Ratios
From a lender's perspective, your ability to purchase a home depends largely on the following factors:
Front-End Ratio. The front-end ratio is the percentage of your yearly gross income dedicated toward paying your mortgage each month. Your mortgage payment consists of four components: principal, interest, taxes and insurance (often collectively referred to as PITI) (see Understanding The Mortgage Payment Structure). A good rule of thumb is that PITI should not exceed 28% of your gross income. However, many lenders let borrowers exceed 30%, and some even let borrowers exceed 40%.
Back-End Ratio. The back-end ratio, also known as the debt-to-income ratio (DTI), calculates the percentage of your gross income required to cover your debts. Debts include your mortgage, credit card payments, child support and other loan payments. Most lenders recommend that your DTI does not exceed 36% of your gross income. To calculate your maximum monthly debt based on this ratio, multiply your gross income by 0.36 and divide by 12. For example, if you earn $100,000 per year, your maximum monthly debt expenses should not exceed $3,000.
Down Payment. A down payment of at least 20% of the purchase price of the home minimizes insurance requirements, but many lenders let buyers purchase a home with significantly smaller down payments. The down payment has a direct impact on your mortgage payment, and, therefore, also on both the front-end and back-end ratios. Larger down payments enable buyers to purchase more expensive homes.
Being House Poor: a Personal Decision
To be 'house poor' means that the costs of paying for, and maintaining, your home take up such a large percentage of your income that you don't have enough money left to cover other expenses. As grim as that sounds, many people choose to be 'house poor' because they believe that it's wise to purchase the most expensive home that they can afford, regardless of how far they have to stretch. Their theory is that, over time, their income will increase as a result of raises and promotions, making that expensive mortgage a smaller and smaller percentage of their monthly expenses.
Clearly, those who choose to be 'house poor' have their own set personal criteria determining what kind of home they can afford. (To learn more about the home costs, see To Rent Or Buy? The Financial Issues - Part 1, Home-Equity Loans: The Costs and The Home-Equity Loan: What It Is And How It Works.)
The decision of whether or not to be 'house poor' is largely a matter of personal choice – since getting approved for a mortgage doesn't mean that you can actually afford the payments. So, in addition to the lender's criteria, consider the following issues and set some decisive factors of your own:
Income. When contemplating your ability to pay a mortgage, ask yourself the following questions: Are you relying on two incomes just to pay the bills? Is your job stable? Can you easily find another job that pays the same, or better, wages if you should lose your current job?Expenses The calculation of your back-end-ratio will include most of your current debt expenses, but what about other expenses that you haven't generated yet? Will you have kids in college someday? Do you have plans to buy a new car, truck or boat? Does your family enjoy a yearly vacation?
Lifestyle. Are you willing to change your lifestyle to get the house you want? If fewer trips to the mall and a little tightening of the budget doesn't bother you, applying a higher back-end-ratio might work out fine. If you can't live without that double mocha cappuccino every morning, you might want to play it safe, and take a more conservative approach to that mortgage payment.
Personality. No two people have the same personality, regardless of their income. Some people can sleep soundly at night knowing that they owe $5,000 per month for the next 30 years, while others fret over a payment half that size. The prospect of refinancing the house in order to afford payments on a new car would drive some people crazy while not worrying others at all. If you keep your personality in mind when shopping for a new house, you are likely to be pleased with your purchase.
Beyond the Mortgage
Buying a new home is an exciting adventure. But many prospective homeowners, caught up in the thrill of searching for their dream house, forget to pause and consider the financial responsibilities of homeownership. While the mortgage is certainly the largest and most visible cost associated with a home, there are a host of additional expenses, some of which don't go away even after the mortgage is paid off. Smart shoppers would do well to keep the following items in mind:
Maintenance. Even if you build a new home, it won't stay new forever, nor will those expensive major appliances, such as stoves, dishwashers and refrigerators. The same applies to the roof, furnace, driveway, carpet and even the paint on the walls. If you are 'house poor' when you take on that first mortgage payment, you could find yourself in a difficult situation if your finances haven't improved by the time your home is in need of major repairs.
Utilities. Heat, light, water, sewage, trash removal, cable television and telephone services all cost money. These expenses are not included in the front-end ratio, nor are they calculated in the back-end ratio. But these expenses are unavoidable for most homeowners.
Association Fees. Many homes in planned communities assess monthly or yearly association fees. Sometimes these fees are less than $100 per year, other times they are several hundred dollars per month. Ask about association fees prior to making a purchase. Find out about what the fee covers. In some communities, it includes lawn maintenance, snow removal, a community pool and other services. In other communities, the association fee covers little more than the administrative costs of hiring an attorney to encourage everyone in the neighborhood to maintain the exterior appearance of their homes. While an increasing number of lenders include association fees in the front-end ratio, it pays to remember that these fees are likely to increase over time.
Furniture and Décor. Drive through almost any community of new homes after the sun goes down, and you're likely to notice some interior lights illuminating big, empty rooms, which you can see only because those big, beautiful houses don't have any window coverings. This isn't the latest decorating trend. It's the result of a family that spent all their money on the house, and now can't afford curtains or furniture. Before you buy a new house, take a good look around the number of rooms that will need to be furnished and the number of windows that will need to be covered.
Think Before You Buy
The cost of a home is the single largest personal expense most people will ever face. Prior to taking on such an enormous debt, take the time to do the math. After you run the numbers, consider your personal situation, and think about your present and future lifestyle into the next three decades. Make an informed decision, and be sure to purchase a home that you can afford without compromising your future.
(For a one-stop shop on subprime mortgages and the subprime meltdown, check out the Subprime Mortgages Feature.)
Home & AutoLease now and pay later can work – for a select few.
Home & AutoDetails on the upside and risks of this type of deal for both the owner and the buyer.
Home & AutoRoofing your home is very important, that’s why you should choose a roof specifically designed to handle your area’s climate.
Mutual Funds & ETFsLearn about the iShares US Real Estate fund, which holds shares of equity and nonequity real estate investment trusts incorporated in the United States.
Home & AutoEvolving Swiss property laws mean that Swiss ski chalets have become precious commodities – and excellent investments, even if you're not British royalty.
Credit & LoansCalculate all the particulars of a loan using Excel, and set up a schedule of repayment for a mortgage or any other loan.
Home & AutoThe pros and cons of hosting short-term rentals in your home.
Credit & LoansA nonperforming asset is a loan made by a financial institution to a borrower who has failed to make any scheduled payments for at least 90 days.
InsuranceTips for getting the best protection for your place and possessions.
Credit & LoansUsing an online mortgage lender can be convenient, but how do you know you can trust one? Follow these tips to make sure the lender is legit.
The value of an asset less the value of all liabilities on that ...
A metric used in capital budgeting measuring the profitability ...
An insurance policy covering losses that result from a policyholder ...
This law (Title VIII of the Civil Rights Act of 1968) forbids ...
A short-term loan used to finance the building of a home or another ...
The projected total cost that a reverse mortgage holder should ...
A debt-to-income ratio is a personal finance measure that compares the amount of debt you have to your overall income. Lenders, ... Read Full Answer >>
Yes, you can buy homes directly from Fannie Mae. Fannie Mae (the Federal National Mortgage Association, or FNMA) is a government-sponsored ... Read Full Answer >>
Private mortgage insurance (PMI) is a type of insurance policy that protects lenders from the risk of default and foreclosure, ... Read Full Answer >>
A debt-to-income ratio (DTI) is a personal finance measure that compares the amount of debt you have to your overall income. ... Read Full Answer >>
Fannie Mae (the Federal National Mortgage Association, or FNMA) is a government-sponsored enterprise (GSE) established in ... Read Full Answer >>
Once you reach 59.5, you can use the funds in your 401(k) retirement savings account to buy a house or any other expense ... Read Full Answer >>